A. The Current Net Capital Rule

The Commission adopted the net capital rule in substantially its current form in 1975. The Rule requires every broker-dealer to maintain specified minimum levels of liquid assets, or net capital. The Rule requires broker-dealers to maintain sufficient liquid assets in order to enable those firms that fall below the minimum net capital requirements to liquidate in an orderly fashion. The Rule is designed to protect the customers of a broker-dealer from losses upon the broker-dealer's failure. The Rule requires different minimum levels of capital based upon the nature of the firm's business and whether a broker-dealer handles customer funds or securities.

In calculating the capital requirement, the Rule requires a broker-dealer to deduct from its net worth certain percentages, known as haircuts, of the value of the securities and commodities positions in the firm's portfolio. The applicable percentage haircut is designed to provide protection from the market risk, credit risk, and other risks inherent in particular positions. Discounting the value of a broker-dealer's proprietary positions provides a capital cushion in case the portfolio value of the broker-dealer's positions decline.

The Rule requires a broker-dealer to compute its haircuts by multiplying the market value of its securities positions by prescribed percentages. For example, a broker-dealer's haircut for equity securities is equal to 15 percent of the market value of the greater of the long or short equity position plus 15 percent of the market value of the lesser position, but only to the extent this position exceeds 25 percent of the greater position¹. In contrast to the uniform haircut for equity securities, the haircuts for several types of interest rate sensitive securities, such as government securities, are directly related to the time remaining until the particular security matures. The Rule uses a sliding scale of haircut percentages with these securities because changes in interest rates will usually have a greater impact on the price of securities with longer remaining maturities compared to those securities with shorter remaining maturities. For example, there is no haircut on government securities with less than three months remaining maturity, but there is a six percent haircut on government securities with 25 years or more remaining maturity.

The Commission believes the Rule has worked well over the years. The Commission and the self-regulatory organizations ("SROs") have generally been able to identify at early stages broker-dealers that are experiencing financial problems and to supervise self-liquidations of failing securities firms. This early regulatory intervention has helped to avoid customer losses and the need for formal proceedings under the Securities Investor Protection Act of 1970.

B. Prior Relevant Actions

Since 1993, the Commission has undertaken a number of initiatives to better understand how securities firms manage market and credit risk and to evaluate whether the firms' risk management techniques could be incorporated into the net capital rule. This section reviews four of the Commission's initiatives as well as recent rules addressing capital requirements for banks adopted by the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (collectively, the "U.S. Banking Agencies").

1. 1993 Concept Release

In May 1993, the Commission began a comprehensive review of the Rule by issuing a concept release soliciting comment on alternative methods for computing haircuts on derivative financial instruments ("Concept Release").² Although the Concept Release's focus was on derivative instruments, the Commission intended to commence a dialogue with the securities industry regarding how the Rule could better reflect the market and credit risks inherent in a broker-dealer's proprietary securities portfolio. At that time, the Commission envisioned a multi-step revision of the net capital rule that would substantially change how broker-dealers calculate the market and credit risk haircuts arising from their proprietary positions.

2. Derivatives Policy Group

The Derivatives Policy Group ("DPG"), consisting of the six U.S. firms³ most active in the over-the-counter ("OTC") derivatives market, was formed at the Commission's request to address the public policy issues arising from the activities of unregistered affiliates of registered broker-dealers and registered futures commission merchants. In March 1995, after discussions with the Commission, the DPG published its Framework for Voluntary Oversight ("Framework") under which the members of the DPG agreed to report voluntarily to the Commission on their activities in the OTC derivatives market.⁴ The Framework provides for the use of proprietary statistical models to measure capital at risk due to the firms' OTC derivatives activities; however, the Framework was not intended to be used as a method for calculating minimum capital standards for the DPG firms.

For purposes of using models to measure capital at risk, the DPG defines risk of loss, or "capital at risk," to be "the maximum loss expected to be exceeded with a probability of one percent over a two-week holding period."⁵ The Framework covers several products, including: interest rate, currency, equity, and commodity swaps; OTC options (including caps, floors, and collars); and currency forwards (i.e., currency transactions of more than a two-day duration, except that firms may elect to include only currency transactions of 14 days or more of duration). The Framework provides that each firm's model must capture all material sources of market risk that might impact the value of the firm's positions, including nine specific material sources of risk, or core risk factors, based on interest rate shocks, changes in equity values, and changes in exchange rates.⁶

Each DPG firm agreed to calculate capital at risk under two scenarios. Under the first scenario, each firm would independently determine the size of the shocks used to calculate its capital at risk. Under the second scenario, each firm would calculate its capital at risk due to certain Commission specified, hypothetical large shocks to the core risk factors. The purposes of preparing a second set of capital at risk data are to assist the Commission in comparing volatility among the firms' portfolios and to evaluate the usefulness of the firms' models in measuring market risk during times of unusual market stress.

The Framework does not specify minimum correlations between securities that are to be used in the models. The Framework states that there are many generally accepted methods for estimating historical or market-implied volatilities and correlations and, instead of utilizing predetermined correlation factors, the Framework provides that hedging would be permitted where contracts and instruments within the category exhibit an appropriately high degree of positive price correlation." Thus, the degree to which firms would recognize positions as hedges was left to the individual discretion of each firm. The Framework notes, however, that estimates of volatility and correlation may not be accurate during times of market stress.

The Framework also sets forth common audit and verification procedures of the technical and performance characteristics of the models. Under the Framework, the firms are responsible for making all computations necessary for purposes of assessing risk in relation to capital on a regular basis and to provide such computations on a current basis upon request. Under the Framework, the inventory pricing and modelling procedures of firms are to be reviewed at least annually by independent auditors or consultants. The independent auditors or consultants provide reports summarizing the results of their reviews, and the firms provide the audit reports to the Commission.

Under the Framework, the DPG firms have enhanced reporting requirements regarding their exposure to credit risk. The information reported to the Commission falls primarily into two principal categories: credit concentration and portfolio credit quality. Credit concentration in the portfolio is reported by separately identifying the top 20 net exposures on a counterparty-by-counterparty basis. The credit quality of the portfolio is reported by aggregating for each counterparty the gross and net replacement value and net exposure of the firm. Credit information also is categorized by credit rating, industry, and geographic location.

The Framework established risk management guidelines that provide a comprehensive framework for the DPG firms to implement their business judgments as to the appropriate scope and level of their OTC derivatives activities. The Framework provides that each firm's board of directors should adopt written guidelines addressing the scope of permitted activities, the acceptable levels of credit and market risk, and the structure and independence of the risk monitoring and risk management processes and related organizational checks and balances from the firm's trading operations. Senior management should also implement independent risk measuring and risk monitoring processes to manage risk within the guidelines established by the board of directors.

3. Theoretical Options Pricing Models

In February 1997, the Commission completed an important step in its review of the net capital rule by amending the Rule to allow broker-dealers to use theoretical option pricing models to determine capital charges for listed equity, index, and currency options, and related positions that hedge these options.⁷ The amendment permits broker-dealers to use a model (other than a proprietary model) maintained and operated by a third-party source ("Third-Party Source") and approved by a designated examining authority ("DEA").⁸ The Third-Party Source is required to collect certain information on a daily basis concerning different options series.⁹ Using this information, the Third-Party Source measures the implied volatility for each option series and inputs to the model the resulting implied volatility for each option series. For each option series, the model calculates theoretical prices at 10 equidistant valuation points using specified increases and decreases in the underlying instrument.

After the model calculates the theoretical gain or loss valuations, the Third-Party Source provides the valuations to broker-dealers. Broker-dealers download this information into a spreadsheet from which the broker-dealer calculates the profit or loss for each of its proprietary and market-maker options positions. The greatest loss at any one valuation point is the haircut. This amendment to the Rule was a milestone because it was the first time the Commission allowed modelling techniques for regulatory capital purposes.

4. OTC Derivatives Dealers

Simultaneously with this release, the Commission is proposing a new limited regulatory regime for OTC derivatives dealers.¹⁰ Under this regime, OTC derivatives dealers could register with the Commission and be subject to specialized net capital requirements. The Commission is considering requiring OTC derivatives dealers registered under this framework to maintain tentative net capital of not less than $100 million and net capital of not less than $20 million. As part of this proposal, the Commission is contemplating giving OTC derivatives dealers the option of taking either the existing securities haircuts or haircuts based on statistical models. OTC derivatives dealers electing to use models would have to calculate potential losses and specific capital charges for both market and credit risk. These OTC derivatives dealers also would have to maintain models that meet certain minimum qualitative and quantitative requirements that are substantially similar to the requirements set forth in the U.S. Banking Agencies' rules.

5. U.S. Banking Agencies

In August 1996, the U.S. Banking Agencies adopted rules incorporating into their bank capital requirements risk-based capital standards for market risk that cover debt and equity positions in the trading accounts of certain banks and bank holding companies and foreign exchange and commodity positions wherever held by the institutions. The U.S. Banking Agencies' rules were designed to implement the Basle Committee on Banking Supervision's ("Basle Committee")¹¹ agreement on a model based approach to cover market risk. These rules apply to any bank or bank holding company whose trading activity equals ten percent or more of its total assets, or whose trading activity equals $1 billion or more. The U.S. Banking Agencies' final rules became effective January 1, 1997 and compliance will be mandatory by January 1, 1998. Institutions that do not meet these minimum securities trading thresholds will not be subject to market risk capital requirements.

The U.S. Banking Agencies' rule amendments require affected banks or bank holding companies to adjust their risk-based capital ratio to reflect market risk by taking into account the general market risk and specific risk of debt and equity positions in their trading accounts.¹² These institutions also must take into account the general market risk associated with their foreign exchange and commodity positions, wherever located. The capital charge for market risk must be calculated by using the institution's own internal model.

Footnotes:

(1) For example, in the case where a firm has a long position of $100,000 in equity securities and a short position of $50,000 in equity securities, that firm's haircut for equity securities would be: